When someone thinks about the mining industry, there is one name that comes to mind: Glencore (GLEN.L). The Anglo-Swiss company was founded in 1974 as Marc Rich + Co AG, before being renamed Glencore International in a management buyout. The company is specialised in producing, refinement and trading of a wide range of commodities, has been listed on both London and Hong Kong Stock Exchange since 2011 and has been included in the FTSE 100 index ever since. From that moment on, the company experienced few years of very good performance. The overall revenues steadily surged between 2011 ($186,152m) and 2013 ($232,694m), reflecting health in all its business lines, which consist of energy products (oil and coal and marketing activities, 60% of FY14 revenues, 26% of FY14 EBITDA), metals and minerals (copper, zinc, nickel, ferroalloys and aluminium and marketing activities, 30% of FY14 revenues, 67% of FY14 EBITDA) and agricultural products (grains, oils/oilseeds, cotton and sugar and marketing activities, 10% of FY14 revenues, 9% of FY14 EBITDA). The company has operations in Americas, Asia, Europe, Africa and Oceania.

Chart 1: EBITDA evolution by business line (source of chart data: company data)

Chart 1: EBITDA evolution by business line (source of chart data: company data)

Glencore underwent a huge all-share merger with Xstrata in 2013, which led to the establishment of Glencore plc, one of the biggest commodity producer and trader in the world, with combined revenues of $232,694m as of FY13. Nonetheless, the following years have been fairly harsh, as they were marked by a sharp plunge in commodity prices, which is still underway. The weakness of emerging market economic data (notably in China, Brazil and Turkey) further weighted on all commodities. Year-to-date, both zinc and copper lost some 16%, whilst nickel fell by 30% and iron ore declined by 17%.

Overall, 2015 has been a very challenging year, particularly for Glencore. A note was released by Investec on 28th September which emphasised the deterioration of the company’s fundamentals due to plummeting commodity prices. Surprisingly, the note received huge attention as Glencore’s stock price declined by roughly 29% on a single trading day. At the beginning of September, both S&P and Moody’s changed their outlook on Glencore’s debt from stable to negative: the company’s bonds’ yields and CDS have skyrocketed to near junk, despite still retaining an investment grade rating (BBB/negative and Baa2/negative according to S&P and Moody’s respectively). The 5-year unsecured bond traded at an astonishing yield of 10.0%.

Chart 2: YTM of GLEN.L unsecured GBP-denominated bond maturing on 27/05/2020 and paying 7.375% annual coupon (source of chart data: Bloomberg)

Chart 2: YTM of GLEN.L unsecured GBP-denominated bond maturing on 27/05/2020 and paying 7.375% annual coupon (source of chart data: Bloomberg)

After more and more concerns arose with regards to the firm’s ability to pay back its significant amount of debt (gross debt of $50,481m and net debt of $29,642m at the end of June 2015) in a low-commodity-prices environment, Glencore has stepped up its efforts on the path of debt reduction. In fact, the company adopted extraordinary measures to cut net debt by $10bn to $20bn by FY16 end. We believe that the $10bn-worth package of proposed measures will achieve the desired objective of avoiding a downgrade of Glencore’s debt to junk.

First, Glencore issued $2.5bn in equity: 78% was underwritten by Morgan Stanley and Citi and 22% was directly acquired by senior management of the company, a positive signal that executives are taking a strong position in their own company’s shares. Second, the commodity miner-cum-trader announced $5bn in annual savings from further cost-cutting measures, including scrapping $2.4bn in dividends, $1.5bn in savings from a reduction in net working capital and $1bn from capex reduction. Third, the company said it would sell $2bn of non-core assets, including a minority stake in its agricultural business and precious metals by-products from copper mines in Latin America. Finally, on October 12th Glencore announced it would sell two important copper mines in Australia and Chile, which are valued between $500m and $1bn. At the same time, the commodity behemoth undertook two measures to sustain commodity prices. First, it declared that it would cut zinc production by 500,000 metric tonnes (1/3 of total Glencore output and 4% of world output). Second, it decided to cut copper output by 400,000 tonnes. Markets positively reacted to this firm reaction and Glencore’s stock climbed 40%.

We deeply analysed Glencore’s fundamentals to assess whether the proposed plan is feasible. Revenues for the first half of 2015 have shrunk when compared to H1 2014. This has been mainly due to a decline in revenue from energy products (H1 2015: $42,962m vs. H1 2014: $71,306m), whereas metals & minerals and agricultural segments have remained fairly stable. On the other hand, EBITDA has declined (H1 2015: $4,611m vs H1 2014: $6,464m), but is fairly aligned to the level of the previous years (FY13: $10,466m vs. LTM: $10,911m). Yet, what is perhaps more important is the effort the company has put on the reduction of net debt level which was severely augmented due to 2013 merger with Xstrata.

Net debt (calculated by deducting cash, marketable securities and readily marketable inventories from gross debt) has been reduced from $37,665m in H1 2014 to $29,642m in H1 2015. Net capex has been already reduced from a high of $9bn in FY13 to $7bn in the last twelve months. This means that there is still space to implement the further $1bn cut. Net working capital has been reduced by more than 30% from FY13 to $14bn (LTM). Readily marketable inventories remain high as a percentage of inventories (75% LTM), a signal that further cuts to free up cash and reduce leverage are possible. Even if declining, EBITDA covers 9.4x net cash interest outflows. Cash available for net debt reduction has increased steadily in the last three semesters, reaching around $2.5bn in H1 2015 from a negative figure of -$2bn in H1 2014. LTM net leverage (EBITDA/net debt) is at 2.7x.

Chart 3: Relevant credit statistics for GLEN.L (source of chart data: company data / BSIC)

Chart 3: Relevant credit statistics for GLEN.L (source of chart data: company data / BSIC)

Therefore, we believe the market overreacted and the bond yield excessively spiked. Hence, the valuation does not support the current YTM of its bonds, treated as non-investment grade (as a reference, the YTM on Bloomberg GBP High Yield Corporate Bond Index was 6.16% as of 14th October 2015). What we would suggest in this case is to bet against Glencore’s default. On the basis of that, we will buy Glencore’s GBP-denominated bond maturing on 27th May 2020, which has an 8.88% YTM, a 7.375% coupon rate paid annually and a price of 94.45 (at 16th October 2015).

The main risks implied in this view are: 1) externally, a further deterioration of commodity prices, especially copper, which makes up alone almost 9% of Glencore’s LTM revenues; 2) internally, difficulties in the execution of the proposed $10bn-package of measures to reduce net debt. After analysing the company’s fundamentals, we think that the greatest concern comes from the external headwind. In fact, commodity prices may remain low for longer than expected, especially due to the well-known slowdown of Chinese demand. We have computed some rolling correlations between Glencore’s stock price and copper price. The results are pretty clear: since its IPO, Glencore’s stock price has been quite strongly positively correlated with copper price, a signal that low copper prices negatively affect Glencore’s revenues and profits.

Chart 4: Rolling correlations (50days average, 100 days and 200 days) between GLEN.L stock price and copper price (source of chart data: Bloomberg)

Chart 4: Rolling correlations (50days average, 100 days and 200 days) between GLEN.L stock price and copper price (source of chart data: Bloomberg)

Given our view that the company will not default, two scenarios open up. First, in case commodity prices (and in particular copper prices) remain low or decrease even more, rating agencies might downgrade Glencore’s debt, despite its debt-reduction plan. If this happens, we suggest a buy-and-hold strategy for our selected bond. If instead there is a recovery in commodity prices and Glencore executes the emergency plan efficiently, yields could come back to levels consistent with an investment-grade rating, opening up a good opportunity of realizing a capital gain on the bond.

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